When people don’t behave according to economic models

What falls outside the standard assumptions and models of economics? How does that matter for development? Last week, the Africa Chief Economist’s Office and the Development Economics Research Group of the World Bank sponsored a star-studded course exploring exactly this issue.

Nobel Prize winner George Akerlof highlighted how, because of all the advantages of markets, we ignore the traps that come along with them. Sellers can deceive buyers and prey on their unconscious biases, lack of self-control, and naiveté.

Using his famous “lemons” market example, Akerlof showed that, instead of there being no equilibrium, naïve buyers will in equilibrium buy poor-quality used cars. He calls this phenomenon “Phishing for Phools”.

Decisions are also consistently affected by beliefs about what is right and what is normal, the “framing” of our choices. World Bank economist Karla Hoff showed how soap operas have dramatically affected people’s beliefs about reconciliation and a willingness to disagree with leaders in post-genocide Rwanda; they have also positively affected views of women’s roles in India. Likewise, quotas on women community leaders in India have transformed people’s views on the appropriateness of women in leadership positions. Not only is framing powerful: Popular media can be used to shape frames and open people to a wider array of choices.

Esther Duflo of MIT showed how a rational decision maker could be affected by hope and hopelessness, often leaving him or her in a poverty trap. Imagine a business which must cross a certain threshold to reach high profitability. A small business owner who doesn’t believe she has a chance of ever crossing that line may decide it isn’t worth doing her best on other business decisions. Likewise, someone who doesn’t believe they’ll ever be truly healthy may not see a point in investing in nutrition. “A little bit of hope allows people to realize their potential,” she said.

Taking the long view, Nathan Nunn of Harvard University demonstrated how slavery patterns hundreds of years ago still affect trust today, and how the type of agriculture employed by ancestors (plow or hoe?) affects gender views today. These historically determined views can be slow to evolve, a counter to the frame-shifting examples given by Hoff.

A panel of researchers in behavioral economics highlighted that behavioral economics can inform the design of policies and programs to influence take-up and compliance. Shanta Devarajan (if you don’t know who he is, you must be new to the blog) underlined that some of the apparent deviations from rational decision making may be due to political forces rather than psychological biases. At the same time, political actors are subject to these same biases.

Beyond being interesting, these insights need to be applied to the first-order poverty problems facing the world today. How can knowledge of framing, hope, and culture be put to work to reduce poverty?

Behavioral economics as a development mantra has undoubted academic legitimacy. It instills confidence within the development community (scholars and practitionners) that we now know the culprit of persisting poverty in Africa, South Asia, and Latin America, and can finally bring an end to it one field experiment at a time.
But, there are lingering questions still needing to be addressed before economic modelling can be dismissed as a legitimate method development inquiry: (i) Just how did the West fought poverty within itself prior to behavioral economics? (ii) If the standard assumptions and models of economics had little to do with the rise of the West, Japan, Korea, and now China, what did? (iii) What is different about poverty in the West --more than a century ago--, in Korea-- less than a century ago--, and poverty in the developing world today? (iv) How can behavioral economics change the culture of doing things where a section of the population (sometime the most powerful one) gains from the status quo?

Most of the behavioral economists I know would argue that behavioral economics is a supplement, not a replacement for traditional economics thinking. The argument is not the traditional economics gets everything wrong, but that it gets some things wrong and that supplementing it with behavioral work can help get some of those things right. Some of the insights discussed at the course, such as Esther Duflo's comments about hope, or Sendhil's discussions of the importance of reminders and salience, can clearly be used to tailor micro development interventions to improve take-up and help the poor save and invest more. Exactly how we use it to solve some of the government failure questions is, I believe, more challenging.
Shanta's "Concluding Remarks" video, linked here, does a nice job of summing up this point: Let's not throw the traditional economics baby out with the bathwater.

In fact, I see the new trend in behavioral economics as extensions of the consumer behavior theory. What happens if nudging or something else, traditionally education, changes the elasticity of demand?...more of the same